ABC Corp. manufactures television sets and computer monitors. The company is considering introducing a new 40” flat screen television/monitor. The company’s CFO collected the following information about the proposed product.
(1) The project has an anticipated economic life of 5 years.
(2) The company will have to purchase a new machine to produce the screens. The up-front cost (t = 0) is $4,000,000. The machine will be depreciated on a straight-line basis over 5 years. The company anticipates that the machine will last for five years and then have no salvage value (i.e., salvage/residual value = 0).
(3) If the company goes ahead with the proposed product, it will have to increase inventory by $280,000 and accounts payable by $80,000 at t = 0. At t = 5, the net working capital will be recovered after the project is completed (so, in this example, the company treats an increase in net working capital as an initial investment that is necessary for the project and the liquidation of the increased net working capital as the liquidation of the project asset; rather than projecting an annual change in net working capital as part of operating cash flow).
(4) The screen is expected to generate sales revenue of $2,000,000 the first year; $4,500,000 the second through fourth years and $3,000,000 in the fifth year. Each year the operating costs (excluding depreciation) are expected to equal 50% of sales revenue brought by the new television.
(5) The company’s interest expense each year will be $350,000.
(6) The new screens are expected to reduce the sales of the company’s large screen TV’s by $500,000 per year.
(7) The company’s (annual) after-tax cost of capital is 12%.
(8) The company’s tax rate is 30%.
Questions: (a) Calculate the project’s initial investment. (b) What is the 3rd year expected incremental operating cash flow? (c) What is the 5th year expected incremental non-operating cash flow (i.e. liquidation of assets/residual CF)? (d) Compute the NPV of the project and determine whether to take on the project.